Discretionary income

What Is Discretionary Income?

Discretionary income is the amount of money an individual or household has available to spend, save, or invest after covering essential expenses and taxes. It represents the portion of income that is not allocated to necessities, making it a key concept in personal finance and broader economic analysis. While often confused with disposable income, discretionary income is a more specific measure, highlighting funds available for non-essential purchases like entertainment, vacations, or luxury goods. Understanding discretionary income is crucial for effective budgeting and achieving financial goals.

History and Origin

The concept of discretionary income, while not having a single historical "invention," gained prominence alongside the development of modern economic thought and the systematic measurement of household finances. As economies matured and consumer spending became a significant driver of growth, economists and financial institutions began to differentiate between necessary and optional expenditures.

A key development in the understanding of household financial well-being, which implicitly tracks discretionary capacity, is the Survey of Consumer Finances (SCF). Conducted triennially by the U.S. Federal Reserve Board in cooperation with the U.S. Treasury Department, the SCF has provided detailed insights into families' balance sheets, incomes, and demographic characteristics since 1983²², ²³. This comprehensive survey helps policymakers and researchers understand how American families save, spend, and borrow, indirectly reflecting trends in discretionary income and its impact on the economy²¹.

Key Takeaways

• Discretionary income is the money left after paying all taxes and essential living expenses.
• It is used for non-essential spending, investments, or savings.
• Economists use discretionary income as an economic indicator to gauge consumer confidence and overall economic health.
• Businesses selling non-essential goods and services are particularly sensitive to fluctuations in discretionary income.
• For individuals, managing discretionary income is vital for building an emergency fund and long-term financial planning.

Formula and Calculation

Calculating discretionary income involves a straightforward subtraction:

Where:

• Gross Income refers to an individual's total earnings before any deductions.
• Taxes include federal, state, and local income taxes, as well as Social Security and Medicare contributions¹⁷, ¹⁸, ¹⁹, ²⁰.
• Essential Expenses are non-negotiable costs required for living, such as housing (rent or mortgage payments), food, utilities, transportation, healthcare, and basic insurance premiums¹⁵, ¹⁶.

For personal budgeting, this formula helps determine what funds remain after all necessary financial obligations are met.

Interpreting the Discretionary Income

Discretionary income provides a clear picture of an individual's financial flexibility. A higher amount suggests greater capacity for saving, investing, or spending on non-essentials, indicating a stronger personal financial position. Conversely, a low or negative discretionary income can signal financial strain, where an individual or household is spending a significant portion, or even all, of their income on necessities and taxes, with little left for other goals¹⁴.

From an economic perspective, changes in aggregate discretionary income are closely watched as an indicator of consumer spending power, which is a major driver of economic growth. When discretionary income rises across a population, it generally leads to increased demand for goods and services beyond basic needs, fueling business expansion and job creation¹³. Conversely, a decline can precede or accompany economic slowdowns or recessions, as consumers cut back on non-essential purchases.

Hypothetical Example

Consider Sarah, who earns an annual gross income of $70,000.

1. Calculate Taxes: After federal, state, and local taxes are deducted, Sarah's take-home pay (disposable income) is $52,000.
2. Identify Essential Expenses: Sarah's annual essential expenses include:
   • Rent: $15,000
   • Groceries: $6,000
   • Utilities: $3,000
   • Transportation: $4,000
   • Health Insurance: $2,000
   • Total Essential Expenses: $15,000 + $6,000 + $3,000 + $4,000 + $2,000 = $30,000
3. Calculate Discretionary Income:
   • Sarah's Disposable Income: $52,000
   • Minus Essential Expenses: $30,000
   • Discretionary Income: $52,000 - $30,000 = $22,000

Sarah has $22,000 in discretionary income per year. This is the money she can choose to save for a down payment on a house, invest in a retirement account, pay down debt faster, or spend on leisure activities.

Practical Applications

Discretionary income is a vital metric in several real-world contexts:

• Individual Financial Management: For individuals, understanding discretionary income is fundamental to creating a realistic budget that prioritizes needs over wants. It guides decisions on how much can be allocated to personal savings, debt reduction, or wealth accumulation through investments¹².
• Economic Analysis: Economists and policymakers monitor aggregate discretionary income to assess the health of the consumer economy. Trends in spending on non-essential goods, often referred to as "personal consumption expenditures," are tracked by entities like the Federal Reserve Bank of St. Louis (FRED) to understand shifts in consumer behavior and overall economic vitality¹⁰, ¹¹. Increased discretionary spending typically signals consumer confidence, while a slowdown can indicate economic headwinds⁸, ⁹.
• Lending and Credit: Lenders may consider a borrower's discretionary income when evaluating creditworthiness, particularly for non-essential loans or lines of credit. It helps assess a borrower's capacity to take on additional financial obligations beyond their fixed costs.
• Government Programs: The U.S. Department of Education, for example, uses a specific calculation involving discretionary income to determine payment amounts for federal student loans under income-driven repayment plans. This calculation often involves the difference between a borrower's adjusted gross income and a percentage of the poverty guideline for their family size⁶, ⁷.

Limitations and Criticisms

While a valuable financial metric, discretionary income has certain limitations:

• Subjectivity of "Essential": The definition of "essential expenses" can be subjective and vary greatly among individuals and households. What one person considers a necessity (e.g., high-speed internet, a specific type of car for commuting) another might consider discretionary. This variability can make direct comparisons challenging and affect the perceived accuracy of the figure for some⁵.
• Dynamic Nature: Discretionary income is not static. It can fluctuate significantly due to changes in employment, income, tax laws, or unexpected essential expenses (e.g., medical emergencies). An individual's discretionary income today might be very different in six months.
• Does Not Reflect Total Financial Health: A high discretionary income alone does not guarantee sound financial health. It does not account for overall debt levels, inadequate savings, or poor financial habits, which could undermine long-term stability even with substantial disposable funds.
• Macro vs. Micro Perspective: While aggregate discretionary income provides insights into broad economic trends, it may not perfectly reflect the financial realities of every individual or segment of the population. For instance, high-income households might disproportionately influence average figures, masking moderation in spending by lower-income households⁴.

Discretionary Income vs. Disposable Income

The terms "discretionary income" and "disposable income" are often used interchangeably, leading to confusion, but they represent distinct financial concepts³.

In essence, disposable income is the money you "take home" after mandatory deductions like income taxes². From this disposable income, you must then cover your essential living costs. What remains after these necessities are paid is your discretionary income, representing the funds truly available for optional uses.

FAQs

Q: Is discretionary income taxed?
A: Discretionary income is not a separate category of income for tax purposes. It is derived from your gross income, which has already been subject to taxes and other mandatory deductions. The money you have as discretionary income is what remains after those tax obligations have been met.

Q: Why is discretionary income important for the economy?
A: Discretionary income is a crucial economic indicator because it directly fuels consumer spending on non-essential goods and services. When consumers have more discretionary income, they tend to spend more, which drives demand, supports businesses, and contributes to economic growth and job creation¹. Conversely, a decline can signal an impending economic slowdown.

Q: How can I increase my discretionary income?
A: You can increase your discretionary income in two primary ways: by increasing your gross income (e.g., through a raise, second job, or new revenue streams) or by reducing your essential expenses. Strategies for the latter might include finding more affordable housing, cutting down on grocery costs, or reducing transportation expenses. Any money saved on necessities effectively becomes part of your discretionary funds.

Q: Can discretionary income be negative?
A: While not a common usage, in a personal budgeting context, if an individual's essential expenses exceed their disposable income (income after taxes), they might be operating with a "negative" discretionary income. This indicates reliance on credit or existing savings to cover basic needs, signifying financial distress.